Since the crash of 2008, cap rates have become an increasingly valuable tool. They are derived from real estate property sales and can be calculated with a standard formula. It is important to keep in mind that calculations are always changing due to demographic trends and US capital market fluctuations. When it comes to cap rates, not only is it vital to understand what they are but how they are affected by certain factors in the commercial real estate industry like market data and interest rates.

What is a Cap Rate?

To start off, let’s define exactly what a cap rate is.Cap rateis the shortened name for “capitalization rate.” In the simplest of terms, a capitalization rate is a measurement of yield on income-producing commercial real estate property. These commercial real estate properties can vary from things like office, industrial, retail, self-storage, hotel and even multi-family properties. You can also describe a commercial real estate property’s cap rate as “the ratio of the property’s net operating income to its purchase price”.

Why Cap Rates Are Important

Cap rates are important because many real estate investors rely on them when negotiating the selling price for income-producing properties. Of course, real estate investors also rely on factors like the location of the property or the prospects of the area it’s in. But cap rates are still one of the most important factor in a real estate investor’s decision.

How Do You Calculate a Cap Rate?

Calculating a cap rate isn’t as difficult as you may think it is. There are a few steps to follow, but once you get the hang of it you will be calculating cap rates in no time. We’re going to break down the steps involved in calculating a cap rate one by one and walk through them to give you a more comprehensive understanding of the math behind the formula. Check out the steps below:

1. Calculate the gross annual income of the commercial real estate property

First thing’s first when it comes to calculating the cap rate of your real estate property—you need to know thegross annual incomeof your property before you can do anything else. You may already know exactly what your gross annual income is, or you may be getting a headache just thinking about it. Don’t let this overly complicated phrase trip you up, your gross annual income is a simple number to calculate.

All you have to do is analyze how much money you’re going to be making from your investment property. Most investors make their money from the rent they get paid on their property. So, if you charge your tenants a monthly rent of $1,000 and you want to know how much income you’re going to make in a year, all you have to do is multiply the price of rent by 12 months, or$1,000 x 12 months = $12,000. There you have it, yourgross annual incomeon your investment property is $12,000.

2. Subtract the operating expenses that come with owning the property

Now that you’ve figured out your gross annual income, the next step to calculating your cap rate is subtracting anyoperating expensesthat you may accrue as a result of owning the property. Operating expenses can be anything from maintenance of the property to insurance, taxes, and property management.

Let’s say your operating expenses are as follows: $500 in maintenance fees, $900 in taxes, and $700 in property management. Keep in mind that these numbers are what you pay per year on your commercial real estate investment property. Adding up all these operating expenses leaves you with a total yearly operating expense of $2,100.

Now you need to subtract that total operating expense from your gross annual income that you found in the step one. The calculation would go a little something like this: $12,000 - $2,100 = $9,900. The number you come up with after this calculation is known as your property’snet operating income.

3. Divide your net operating income by the purchase price of the property

The final step to calculating the cap rate on your investment property is dividing your net income ($9,900) by the original price you purchased the property for. For this example, we’re going to say we purchased this particular property for $100,000.

You may be wondering what this cap rate of 9.9% means for your investment, and whether itis an attractive yield. The answer is, it depends. The range for a the market cap rate varies from market to market. For example if you were looking to invest in Los Angeles, many real estate investors consider a cap rate of 5% to be pretty good. While if you were investing in a lower-cost city like Memphis, you would want to aim for something a little higher, say 10%.

While cap rates are great tools for getting a quick snapshot of the profitability of your investment property, they should not be the only tool used to determine an investment’s health. Other things like market forces, growth potential, location, and the property’s income should be considered in tandem with the property’s cap rate to determine if it’s an attractive commercial real estate property to invest in.